European rates: will the road back to normal be smooth or rocky?

The path to monetary policy normalisation in the Eurozone may be strewn with potential hazards, but it remains negotiable with care, argues Charlie Diebel.

By the time the European Central Bank’s (ECB) three-year quantitative easing (QE) programme comes to its scheduled end in December 2017, over €2 trillion of euro-denominated government, corporate, asset backed and covered bonds will have been purchased. The effectiveness of the programme has long been called into question; but of more significance to investors now is how disruptive the withdrawal of this substantial support could be to the economy and to financial assets.

The decision last December of the central bank’s president, Mario Draghi, to extend the timeline of QE, albeit at a reduced pace of €60 billion a month, suggests that extreme care is being taken to manage the exit in a way that does not endanger the fragile economic recovery. Yet given that managing inflation, rather than shepherding the economy, is the ECB’s primary remit, how will its thinking be altered now that consumer inflation has reached 2.1 per cent, breaching the official target?

The other joker in the pack that could disrupt the ECB’s policy exit is politics. Right wing populism may have been seen off in the recent election in the Netherlands, but a victory for the Front National candidate Marine Le Pen in France’s presidential election in April/May would be seen as a potentially defining moment for the entire European project. Le Pen’s prospects seem remote, but the last year has taught us that nothing is certain in the political arena.

Charlie Diebel, Head of Global Rates at Aviva Investors, assesses the challenges faced by the ECB in the coming months and suggests what might happen as its asset purchases finally come to an end.

Will political concerns influence the ECB’s exit strategy?

The official answer is no. The ECB will insist politics is not its consideration and it will manage policy according to its mandate, which is ostensibly to keep inflation close to its two per cent target. That being said, it stands ready to respond in the event of a political shock, such as providing additional to support the banking system.

In which case, is the French election a concern to the ECB?

Of course, France is in sharp focus given that it is at the heart of the European project. But to view a victory of the right-wing candidate Marine Le Pen in the French presidential election as a threat, you really have to believe it brings ‘redenomination’ risk; in other words France leaving the euro area.

Even if Le Pen were to confound a big deficit in the opinion polls and win the presidency, we would still view a French exit as a close-to-zero probability. This is merely because of the number of hurdles that Le Pen’s party, the Front National, would have to clear for it to happen. The biggest would be the major gains it would need to make in June’s National Assembly elections just for it to be in a position to change the law to enable a referendum. And given how embedded the EU is in the French economic and political system, not to mention the national psyche, that would be an extremely difficult referendum to win.

Of course it is impossible to discount the impact of unforeseen global events, but the victory of the incumbent centrists in the recent Dutch election suggests a rise in the protest vote, rather than a political earthquake, is the most likely outcome of the 2017 election cycle.

Is the economy now strong enough for the ECB to accelerate its exit?

This is the debate in the market. The reality is that it can’t be concluded convincingly that inflation is on a sustained upward path. Many of the energy-related base-effects that have pushed up the headline rate of inflation will soon drop out. So although headline inflation is just over two per cent at the moment, it’s likely to slip back down to one per cent over the next four to five months.

Core inflation, the ECB’s main target, is not going up enough for it to declare victory in its reflationary battle. Furthermore, in three or four months’ time the policy-makers will start to look much less successful in creating inflation if we see the perfect storm of falling oil prices and negative base effects. If that’s the case, we then have to ask how long before inflation materially recovers.

Looking forward from September, the scenario of improving growth and inflation starting to recover from its summer dip would point to the ECB extending its quantitative easing (QE) purchases from the end of December into 2018, albeit at a slower pace. A measured approach would also chime with its concerns about the impact of reduced corporate bond buying on credit spreads. The ECB sees the support of credit demand as one of its key weapons in getting the economy to self-heal. It will be desperate not to disrupt that process.

How will peripheral spreads develop as the ECB exit plays out?

Everyone thinks the end of QE will be negative for countries such as Italy because the ECB is the market’s primary source of demand. That’s not actually true in my view because Italian debt has strong domestic sponsorship. Italy still has positive yields and retail investors are happy to participate. But while the end of QE could see periphery spreads compress rather than widen, it is likely to be less of a consequence of a periphery rally and more a re-pricing of German debt. The German bond market has been distorted significantly by the side-effects of the county’s strict control of debt-to-GDP levels, in accordance with the Maastricht treaty, against the backdrop of massive ECB asset purchasing.

The increasing scarcity of longer-dated German bonds has compelled the ECB to remove the deposit floor and broaden the scope of its purchasing, with the result that yields of two-year maturities have been driven deep into negative territory (to a low of -0.95 per cent on 24 February1). So when the forced buying of bonds winds down and the markets start to rebalance, the main story in European fixed income is which market sees that biggest correction. We believe it will most likely be Germany. When bonds are bought against all economic sense, there have to be repercussions.

What could the ECB learn from the US’ exit from QE?

The US Federal Reserve made the last asset purchase of its $3.7 trillion QE programme in October 2014 and the market barely reacted. A brief spike in benchmark Treasury yields in mid-September was followed by a continuation of the downward trend that had started at the beginning of the year and ended in July 2016.

Having learned from its ‘taper tantrum’ error, the Fed was careful to flag the criteria that needed to met for the exit to get underway. Mario Draghi appears to have heeded that lesson if his determined avoidance of the word ‘tapering’ is anything to go by.

If he follows the Fed’s lead, he will reassure the market there will be no hike in interest rates until the exit from QE is complete. Indeed, he may need to be more nuanced in his guidance; perhaps noting the withdrawal of the negative interest rate need not necessarily be the precursor of an automatic tightening cycle. In terms of the technical aspects of the exit, allowing existing bond holdings to expire without replacing them, as per the Fed’s strategy, would be in keeping with Draghi’s watchful approach.

1 Source Bloomberg

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 18 April 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0522/31072017

Charlie Diebel

Head of Rates

Main responsibilities

Charlie has primary responsibility for the Rates team. In this role he leads the thought process around the macro overlay for the investment process and drives idea generation across the investment team.

Experience and qualifications

Charlie joined Aviva Investors from Lloyds Banking Group where he was the head of market strategy covering rates, FX, quantitative and technical approaches to market analysis.
Charlie has more than 20 years’ experience researching G7 derivative and bond markets with specific emphasis on euro zone and US markets. Over his long career, he has held senior management roles at Societe Generale, Royal Bank of Scotland and Nomura International.